Municipal bonds (munis) are debt obligations issued by states, counties, cities, school districts, and special authorities to finance public projects. Their defining feature is federal tax exemption on interest income. Interest is also typically exempt from state and local tax if the investor resides in the issuing state — making them especially valuable to investors in high tax brackets. The taxable equivalent yield formula (muni yield ÷ [1 − marginal tax rate]) allows comparison with taxable bonds.
The two primary types are general obligation (GO) bonds, backed by the full taxing power of the issuer, and revenue bonds, supported by income from a specific project (toll road, airport, hospital). GOs are generally considered safer because they can raise taxes to service debt; revenue bonds depend on project cash flows. Revenue bonds include industrial development bonds (IDBs) and private activity bonds, which may be subject to the Alternative Minimum Tax (AMT).
Serial bonds mature in increments over multiple years; term bonds all mature on the same date. The Municipal Securities Rulemaking Board (MSRB) regulates dealers in the municipal market; issuers themselves are exempt from SEC registration requirements under the Tower Amendment.
Key risks include credit risk (though defaults are rare for GO bonds), interest rate risk, call risk (most munis are callable), liquidity risk (the secondary market is less liquid than Treasuries), and tax law risk (Congress could alter the tax exemption).
> Exam tip: On the Series 7 and Series 65/66, master the taxable equivalent yield calculation. Remember: private activity bond interest may be an AMT preference item. Know that the MSRB regulates dealers and brokers, but has no jurisdiction over municipal issuers themselves.